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Portfolio > Portfolio Construction

Bonds Show Hedging Magic in Latest Test to Rebuff 60/40 Haters

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What You Need to Know

  • There are big reasons why bonds — and balanced-portfolio strategies that rely on them — aren’t broken in the age of inflation.
  • A recent study shows if an an investor were to hold only equities, the volatility on the portfolio would be 24.6%; adding 40% bonds takes volatility to 14.2% in recent years.

Bonds have been down all year, but the omicron fallout is a reminder that they are anything but out.

With the S&P 500 posting its biggest slide Friday since February on spread of the new strain, Treasuries rallied big time on haven buying and cushioned the selloff in global risk markets.

The move pushes back against the loud anti-bond brigade on Wall Street, which argues the asset class is a portfolio diversifier no more, citing in-tandem moves with stocks at various points of the pandemic risk cycle.

“It reveals that Treasuries still provide very good cross asset hedging,” Michael Purves, founder of Tallbacken Capital Advisors, wrote in a note. “When there is a macro shock, the bid can be ferocious – strong inflation not withstanding.”

Treasuries were on the backfoot in Monday trading amid the the revival in risk assets, with the yield on the 10-year benchmark retracing about half its Friday move.

Beyond the one-day bounce, there are bigger reasons why bonds — and balanced-portfolio strategies that rely on them — aren’t broken in the age of inflation.

Latest Research

In a recent study, Ardea Investment Management researcher Laura Ryan stress-tested investment strategies across economic regimes. Her data confirms that over the decades, balanced portfolios allocating 40% to fixed income and 60% to shares really do enjoy lower portfolio volatility than those loaded with risk assets — thereby helping risk-adjusted returns.

“The consensus now seems to be that government bonds are not doing their job,” she said in a telephone interview from Sydney, where her research helps inform strategies at the specialist fixed-income manager that targets low-volatility returns. “That argument fails to consider the relative importance of bonds in reducing overall portfolio volatility.”

Ryan’s study shows if an an investor were to hold only equities, the volatility on the portfolio would be 24.6%. Adding 40% bonds takes volatility to 14.2% in recent years. For this reason, the researcher recommends clients keep the faith in the diversifying role of bonds.

“Bonds will continue to provide diversification if bond volatility is lower than equity volatility, even if the correlation is positive,” Ryan said. “They might a less valuable assets compared to their own history as their expected returns over longer-term horizon are much less than equities. But if you want to make sure that you are not going to suffer a wild price swing, then bonds serve that purpose.”

The extent to which bond prices swings drives overall portfolio volatility matters more than the degree to which stocks and debt are correlated, according to the study.

Of course, none of this will assuage those concerned about the prospect of lower returns going forward. Global government bonds have lost 6% so far this year, on course for their worst annual return since 2005. That’s made bonds — and their champions — something of a pariah.

“It’s been one of the more difficult years to be a fixed income PM — we’re certainly not invited to many dinners,” joked Ella Hoxha, senior investment manager at Pictet Asset Management, in an interview with Bloomberg TV Friday.

Still, Hoxha shouldn’t worry too much about her empty social calender. Notwithstanding their recent choppiness in the pandemic and monetary newsflow, Treasuries are a lot calmer than stocks historically speaking — a dynamic that has room to run thanks to interventionist central bankers.

(Image: Shutterstock)

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